The capital structure of a bank plays an important role in preventing losses above an expected loss level. Capital is typically available to banks in different forms, such as equity, reserves and surplus, subordinate bonds, mezzanine capital, hybrid capital, etc. Regulations set by the Central Bank in any jurisdiction typically set norms for eligibility of different capital instruments and the adequacy of this capital in proportion to the risk associated with a bank's assets and operations. For instance, the Basel Accord issued by the Basel Committee on Banking Supervision provides recommendations for regulating the capital structure of a financial institution. Specifically, the Basel II accord provides a capital classification system that categories capital as Tier 1, Tier 2 or Tier 3 capital based on the risk absorbing capacity of the capital instruments, with Tier 1 capital bearing the highest risk absorbing capacity followed by Tier 2 and then Tier 3. The Basel II accord also provides a capital to risk adequacy ratio CRAR (i.e., the ratio of eligible capital to risk weighted assets) and constraints on the maximum and/or minimum level of capital within each Tier, i.e., Tier 1, Tier 2 and Tier 3 capital and the interrelationship between each Tier.
In order to hold an optimal amount of capital and eventually optimize the associated risk return trade off, a financial institution may develop a long-term capital plan spanning a multiple year horizon. Within a financial institution, the capital planning process may require input from different divisions, such as the Risk Management division, Finance division and Treasury division. The Risk Management division of a bank is responsible for estimating the economic capital (ECAP) over multiple time steps. This process is usually an outcome of combining Economic Capital of individual risk types by using aggregation techniques to arrive at a balance sheet economic capital figure. One of the main purpose of ECAP is to ensure that the level of capital within a bank is sufficient to achieve a desired debt rating in order to withstand the risk of unexpected losses, occurring at a desired confidence level. The Risk Management division may also perform stress testing of the ECAP estimate so that the bank is aware of the level of capital that it might require in the worst case scenario. The Finance Division of a bank is typically responsible for maintaining the capital of the bank at the prescribed regulatory level so that a bank can do business as usual. The Finance Division ensures that the bank achieves the minimum stipulated CRAR The Treasury Division is typically responsible for managing the physical stock of capital based on different management recommendations (for example asset classes for investment of capital), and for this purpose accessing the financial/capital markets to issue capital, invest surplus capital, and managing capital redemption/amortization that may happen from time to time. Since holistic capital planning is an outcome of a collaborative effort of different divisions in a financial institution, it would be useful to have a mechanism that could pool the resources of the different divisions of a financial institution in a single integrated framework to develop an optimal long-term capital plan.